Complementary Definitions in Financial Market
Fifth session of Forex Training
Welcome back to Forex professional training in financial markets.
In this session we will look at Complementary Definitions in Financial Market; swap, commission, hedging, carry Trade and the effect of swap on trading.
As we mentioned in the last session, there are different ways a broker can claim profit from a party.
One of them is called a spread and the other one is called commission, a fee charged by an agent or agent's company to facilitate transactions between buyers and sellers. This usually happens in future accounts and it is a one off payment.
Commission is very similar to what you would pay if you were buying or selling a house via a real estate agent.
Now if we look at the platform, if you focus on the oil trade that we have made, you can see commission was paid and it was only related to the future trades; there was no mention of commission in the foreign exchange trades.
There are two types of account we have not previously looked at: - NDD (No Dealing Desk) and ECN (Electronic Communication Network).
In these accounts there is a commission for the broker in foreign exchange trades, the same as in future trades. We will discuss these account types in more detail in the future.
We have talked briefly about a swap already and have given you some information about it in the previous session, however, since this is quite a significant and advanced topic, we will talk about it in more detail this time.
Swap or fixed rate of interest is a fee that a party pays for long trades. Swap rates are calculated each day at midnight at broker’s server time.
Trades that have been opened before 00:00 and held open past this time will be subject to swap rates. We will now look at how swap is calculated.
For example, in AUDUSD, AUD interest rate at this moment is 2.5 percent minus USD interest rate, which at this point is 0.25 percent.
Based on this formula the difference in interest rates between AUD and USD is 2.5 minus 0.25 percent, which is equal to 2.25 percent.
As we mentioned before for every dollar one lot is equal to 100,000 and if we multiply that by 2.25%, we will have an annual swap of 2250 dollars and if we divide that number by 360 to indicate daily amounts, it is approximately 6.25 dollars of swap interest value that will be withdrawn from or deposited to your account.
This depends on whether you are buying or selling in your position. Whenever you buy exchange with a higher interest rate, swap will be positive and if you buy exchange with lower interest rate or sell in AUDUSD, swap will be negative.
For better understanding of this, here is an example in AUDUSD. Since AUD has a higher interest rate, your account will be deposited with a positive swap for an open buying positions and a negative swap for an open selling position.
To understand how positive swaps are calculated, look at the following example.
The difference of interest rates, in this case AUDUSD, as we calculated before is 6.25 minus X, which is the brokers cut, which equals Y. Thus, 6.25 – X = Y. So Y is a number less than 6.25 that will be added to your account every night for your AUDUSD open positions.
The calculations for a negative swap, which will be withdrawn from your account every night for any open positions are, like so:
In this case the difference in interest rates is 6.25 dollars minus the brokers cut which means 6.25 dollars minus X equals Z and because interest rate is negative here so Z will be also negative.
Now if you look at the platform, for instance in here we have bought and sold one lot of AUDUSD. If you look closely, the positive swap is 27.40 and the negative swap is -35.93. This means that a positive swap is always less than a negative swap.
This is because the broker’s cut in a positive swap is subtracted and in a negative swap is added because both are negative.
It is important to know that on Wednesdays swap is charged 3 times to accounts due to weekends (market is closed on Saturdays and Sundays).
Therefore, every Wednesday, an open position will be subject to 3 times the value of a positive or a negative swap.
Hedge or Hedging is an investment in an individual exchange in two ways at once. In simple terms, it means to sell and buy a certain asset at the same time.
The purpose of hedging is to guarantee the price of an asset until a specific time in the future. This will insure the offset of potential losses or gains of the asset.
For instance, imagine a businessman is in favour of purchasing a chocolate powder from some country and it takes two or three months for merchandise to be delivered to him.
During this period he may experience dramatic market fluctuation.
It might be a positive or a negative one. Therefore, he also intends to sell the same amount of the chocolate powder he bought by opening a new account at the same time.
With this arrangement, if the price of the chocolate powder rises, so will the asset he bought and his sell position will face losses with the same amount. In basic terms, this means that he will break even.
And vice versa, if the price of the chocolate powder drops, the buying position that he has will make a profit and again their difference will be the same and he will break even again.
In this way, all businessmen can insure their assets within the market. There is also another way, called Arbitrage, which is popular in future trades. We will talk more about this in further sessions.
Next topic is Carry Trades, which are made not only for making profit of position itself, but making profit of interest rate differences.
For instance, if you look at the trade we have done here, which is one lot in AUDUSD, the losses in the next 2 to 3 days will be -24 dollars and its swap rate is 27 dollars which means although the position itself will face losses, its swap is positive.
The longer the position is open, the more swaps it will get and the number will be significant. So carry trades are those that gain profit from interest rate differences or swaps.
These trades are usually made in high rate exchanges. Parties who are interested in these trades will require two different brokers; one is a swap free or interest rate free, and one with a swap.
As you can see from the platform, we have bought and sold once and ended up with a negative swap of -35 dollars and a positive swap of 27 dollars, so to gain a profit you have to deal with a broker with swap.
For positive and negative swaps you have to deal with a broker with swap free or interest rate. One of the brokers who offers a swap free is ICM (International Creative Management Broker).
If you look closely again, positions have been left opened for a few days here and they do not include any swaps.
One lot trade in AUDUSD, which has been in trade with this broker, is not subjected to any swap. Thus, we can buy from other brokers like FXPRO to gain profit from positive swaps, and sell with other brokers with no swap.
In this way we have “hedged”, which means we have made no gain or loss but in time the amount of swap will be increased to a considerable amount.
Considering carry trades, the most famous exchanges in markets that parties are usually interested in are AUDJPY and AUDUSD.
As you noticed, there is a greater tendency to buy exchanges with higher interest rates, which results in a swap.
Therefore, swap affects the process, because traders like to buy so they can gain profit and collect swaps, meaning parties usually draw their attention towards trades in which they make profit and collect swaps at the same time.
If you want to make a right move with this type of exchange, you must have a perfect understanding of a market inflation at the time.
This means, at the time of high inflation, in order to gain profit and swap you should buy, and when experiencing flat market or market downturn you should intend to sell.
For example, the FXPRO broker in AUDUSD for weekly periods, when the market is experiencing inflation, the value of this exchange is rising rapidly.
It has a pretty good profit and swap, and has a zigzag routine in ordinary markets, which is affordable considering the swaps. However, in a market deflation its value will rise again after some sharp decline.
This shows an upward market trend tendency in this currency pair.
That concludes this session, until next time and another session take care.